Have markets come too far too fast? Or should investors stay at the party a while longer?

Investor angst about markets having run too far too fast is predicated on many concerns, the most common of which is valuation. With the strong rally in stocks and sell-off in bonds, many investors and strategists are now asking if markets have become overvalued. The consensus view is that stocks have become expensive and therefore the next correction could be quite meaningful—possibly 10% or 20%.

Our view at the Global Investment Committee—Morgan Stanley’s group of seasoned investment professionals who meet regularly to discuss the global economy and markets—is that U.S. stocks remain fairly priced at worst and downright cheap in the context of such low interest rates. Outside the U.S., stocks are even cheaper given investors’ less optimistic view about growth and/or political concerns in many of these regions.

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Not All Metrics Are Created Equal

One of the problems with valuation metrics is that there are so many of them and everyone has their favorite. Our metric at the Global Investment Committee is simply the consensus bottom-up 12-month forward earnings estimate divided by the average corporate borrowing rate, for which we use Moody’s Baa yield. Right now that sets our “fair value” measure for the S&P 500 today at 2,833.

We focus on the fair value measure described above because it incorporates both earnings and interest rates while many traditional measures ignore interest rates altogether. We think such an omission is fundamentally flawed as lower interest rates can and should have a dramatic effect on valuations.

More importantly, we think the relationship shown in the chart above illustrates that such a measure has done a good job of keeping investors informed about valuation over time. First, it clearly identified the overvaluation in the 1990s for which investors ultimately paid dearly in 2001 and 2002. Second, it did a very good job of explaining why stocks collapsed so badly in 2008 and 2009— earnings forecasts collapsed and corporate borrowing rates rose significantly.

Finally, the chart does a great job of illustrating just how much the financial crisis scarred investors’ psyches and strongly suggests we have yet to reach an excessive level of optimism, or euphoria, during this cyclical bull market. In other words, euphoria is yet to come and we think that period is just beginning.

Predicting "Irrational Exuberance"

Another very good and popular valuation metric is the cyclically adjusted price earnings ratio (CAPE). It’s also known as the “Shiller P/E” after its creator, Nobel laureate and Yale University economist Robert Shiller. Understanding that earnings are highly cyclical due to economic expansions and recessions, the Shiller P/E essentially normalizes earnings by taking the 10-year average historical earnings for the denominator rather than using a single point estimate.

What Shiller discovered is that this measure does not tell us much about the near-term valuation of the broader stock market but in the long term it is exceptionally accurate as you can see below.

In short, the current Shiller P/E has been an uncanny predictor of the 10-year forward compounded annual returns of the stock market. This adds credence to the claim that in the end, valuations are your best margin of safety when investing. Buy a good asset at a good price and you will make a solid return over the long run. Of course the corollary holds as well—don’t overpay or you will be sorry.

Never was this mantra more true than the late 1990s. Obviously, the Shiller P/E was abnormally high in that period and though investors did well in the short term while ignoring these warnings, they ultimately paid the price when the tech bubble burst in 2001 and 2002.

With the Shiller P/E approaching higher levels, many investors have worried about getting fooled again. However, we are still well below the levels reached in the late 1990s and at current levels the Shiller P/E is telling us to expect lower, but not negative returns in the next 10 years. With interest rates so low, that means stocks still look relatively attractive.

While the Shiller P/E has not proven to be a good market timer, we found that we could accurately project near-term prices by using the Shiller P/E from 10 years ago (see below).

Shiller P/E Model Tells Us to Remain Fully Invested in Stocks

Source: Bloomberg, Robert Shiller as of Dec. 30, 2016

The Shiller P/E would have correctly kept you fully invested in U.S. stocks during this entire cyclical bull market. And, it’s still telling us to remain fully invested despite its above-average reading. That’s because next year’s price is based on what the metric was saying back in 2007 and 2008, not what it is saying today.

Specifically, the Shiller methodology is projecting a fairly steep acceleration in the S&P 500 during the next 18 months. It gives us an upside target of 2,778 on the S&P, coincidentally the same target suggested by our fair value model. In other words, both our S&P 500 fair value method and the Shiller P/E support significantly higher equity prices.

Note: This article first appeared in the January 2016 edition of “Positioning,” a publication of the Global Investment Committee, which is available on request. For more information, talk with your Morgan Stanley Financial Advisor, or find one using the locator below.

Risk Considerations

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity.

Stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies.

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Companies paying dividends can reduce or cut payouts at any time.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

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